As you grow within an organization, equity awards can become a greater percentage of your compensation and in turn your overall net worth. Two common types of equity awards are non-qualified stock options (NQSOs) and restricted stock units (RSUs). Some companies, such as Nike, may allow you to choose between NQSOs, RSUs, or a combination of the two. In order to determine what path makes the most sense for you, it will be important to have a financial plan in place that coordinates your equity compensation with your long-term financial goals.
What Are Non-Qualified Stock Options?
NQSOs give you the right to buy a certain number of company shares, at a specified price (known as the exercise price) during a window of time (usually 10 years). Typically, your right cannot be exercised until you have satisfied the vesting requirements set forth by the company.
What Are Restricted Stock Units?
An RSU is a promise from your employer to grant you shares of the company stock in the future if certain restrictions are met, often at no cost to you. Each grant of RSUs also typically has its own vesting schedule.
A major difference between NQSOs and RSUs is the way in which they are taxed. Once NQSOs vest, you can exercise and purchase the shares, but you are not required to do so. If you choose to exercise the options, you will generally recognize ordinary income based on the difference between the market value of the stock and the exercise price. When you subsequently sell the shares, any further increase will be taxed as either a short or long-term capital gain.
Example: Your company gives you the right to purchase 1,000 NQSOs at $20 per share. Assuming you exercise the options at vesting and the market value of the stock is $50, you would have to pay $20,000 to exercise the options and would recognize ordinary income of $30,000. Most companies will also allow you to utilize a cashless exercise. With this type of exercise, you can exercise and sell a portion of your shares to cover the option cost and taxes owed resulting in no cash outflow. After you exercise, you can then choose to either sell your remaining shares right away or keep them in your portfolio.
With RSUs, on the other hand, you typically recognize ordinary income based on the market value of the stock on the vesting date. If you choose to sell the shares immediately, there will likely be minimal tax consequences. However, if you hold onto the shares, any subsequent appreciation will then be taxed as either a short or long-term capital gain.
Example: Your company grants you 1,000 RSUs with a four year vesting schedule (25% vesting per year). Assuming the market price is $80 and 250 shares vest one year after the grant date, you would recognize ordinary income of $20,000. Depending on your financial situation, you may then choose to sell the shares immediately or hold onto the shares and sell them in the future.
RSUs offer limited flexibility in comparison to NQSOs. With NQSOs, you have some control over the timing of the exercise and thus when the taxes from the options are triggered. In the case of RSUs, however, the entire value of RSUs must be reported as ordinary income in the year of vesting.
Your risk tolerance can influence whether you select NQSOs or RSUs. RSUs will almost always have an intrinsic value; whether the value of the company stock increases or decreases they will be worth something as long as the stock price is higher than $0. NQSOs, on the other hand, can have greater upside potential but can be worthless if the market value does not exceed the exercise price. Since the risk is higher with NQSOs, companies also tend to offer more NQSOs than RSUs.
NQSOs and RSUs can both be valuable forms of compensation. However, each has its own set of benefits and drawbacks to consider. If your company is allowing you to choose between NQSOs, RSUs, or a mix of the two, our team of professionals can help you navigate the complexities involved with your equity awards in conjunction with your overall financial plan to help you make sound financial decisions and achieve your long-term goals.
MEET THE AUTHOR
Senior Financial Planner
Tawny Ramones, CFP®, CPA
Aldrich Wealth LP
Tawny specializes in developing and implementing comprehensive financial plans that provide clients the best opportunity to achieve their cash flow, investment, insurance, and estate planning goals. Prior to her career in financial planning, she concentrated on strategic tax planning and compliance for high-net-worth individuals. Tawny received a Bachelor of Science degree in business administration with…
- Financial planning
- Wealth management
- High-net-worth individuals
- Certified Public Accountant
- CERTIFIED FINANCIAL PLANNER™